Goodwill on the Balance Sheet

Investing Lesson 3 - Analyzing a Balance Sheet

At this point in our journey to understanding financial statements, we need to talk about goodwill on the balance sheet. Goodwill is related to a discipline called purchase accounting and it is way beyond the scope of this investing lesson so we're going to have to do a thirty-thousand foot view; enough to give you a decent grasp of the basics of the subject so you have a general idea of what you're seeing when you flip open a Form 10-K or annual report.

Under GAAP accounting rules, goodwill on the balance sheet represents the premium for buying a business above and beyond the identifiable assets of that business. To be more specific, when one company buys another, the amount it pays is called the purchase price. Accountants take the purchase price and subtract it from a company's book value with some other purchase accounting adjustments, such as assigning a certain value to firm's client relationships and mailing list. What is left, and cannot be allocated, is added to goodwill. In past generations, and especially among smaller entrepreneurs, this was also known as "blue sky"; what you paid for a business beyond its inventory, building, fixtures, and cash.

Goodwill has undergone an interesting transformation over the past generation. For decades, when a company bought another company, it could use one of two accounting methods: the pooling of interest method or the purchase method.

When the pooling of interest method was used, the balance sheets of the two businesses were combined and no goodwill was created.

When the purchase method was used, the acquiring company put the premium it paid for the other company on their balance sheet under the goodwill asset. The accounting rules in place at that time required goodwill to be written off over 40 years, much in the same way depreciation and amortization is expensed.

Goodwill Is No Longer Amortized on the Income Statement

These days, that isn't the case. Following some major lobbying by a lot of people who didn't like that writing off goodwill had the effect of distorting economic reality and making earnings appear worse than they really were, what is seen to be a more rational accounting philosophy took hold and goodwill now remains on the balance sheet as an asset, with no annual write-offs, unless it is deemed to be "impaired."

Goodwill impairment testing is complex and can involve things like performing a discounted cash flow analysis of expected cash flows from patents, to provide one illustration, but the notion behind the new treatment is that the value of an excellent business, a truly great business with a lot of franchise value, rarely declines and, in fact, grows.

To give you an idea of how bizarre the past goodwill treatment was, consider The Hershey Company, which has made generations of investors wealthy. When Hershey bought Reese's in June of 1963, Reese's had sales of $14,000,000 per annum. Hershey paid $23,300,000 for the transaction. Today, Reese's peanut butter cups alone produce more than $500,000,000 in annual sales.

With the scope and integration of Hershey, it has all kinds of economies of scale it didn't otherwise have allowing for higher returns on capital.

Far from being impaired, real economic goodwill, which doesn't show up anywhere on the balance sheet, is now exponentially higher than it was at the time of the acquisition. Due to the old accounting rules, though, Hershey doesn't carry any goodwill for Reese's on the balance sheet.

As a value investor, the loss of the goodwill write-offs was somewhat upsetting because companies that had engaged in large acquisitions under the old method tended to have artificially depressed earnings per share. This caused the reported net income applicable to common to be significantly understated relative to owner earnings.

Combined with certain quirks in the treatment of accounting in specific sectors and industries, such as pharmaceuticals, you were confronted with this weird situation in which the actual earning power was materially above the reported earnings, making the shares look much more expensive than they were.